Scott Walker and Real Estate

  The Scott Walker victory rightly has been billed as a blow to labor unions and public employees. But it also signals what will be a significant paring back of public pension funds. More states and municipalities will be moving to end their generous and unsustainable retirement packages, taking the route of corporations and turning defined benefit plans into 401Ks or some equivalent, which will reduce an increasingly impossible taxpayer burden.

The public employee pension fund plan sponsor won’t disappear entirely for quite a while, but the system that pushes tens of billions of dollars into commercial real estate investment each year will enter into a period of stepped up decline and eventual eclipse. And that means less institutional investment coming into the property sector from a major and relied upon capital source. The 401K model and its liquidity requirements have never proved particularly conducive to investing directly into lumpy equity real estate, and cannot be counted on to provide substitute flows. For investment managers who rely on heavy doses of public fund allocations, their business model will require an overhaul in the years ahead. Let’s face it--the whole pension industry as we know it is running out of time.

Under these lugubrious circumstances, I found it amusing that a major institutional asset manager released a “research report” last week forecasting that real assets like real estate and infrastructure would capture 20-25% of institutional investor allocations up from the current 5-10% for mixed asset portfolios, which are dominated by stocks and bonds. Of course, this report came from the division of the company that manages real estate and infrastructure investments. Self-serving sure, I wonder how the stock and fixed income side of this financial institution feels.

Besides trying to drum up business and making everyone in the real estate industry feel better, reports like these don’t have much grounding in reality. I have been hearing for the past 20 years or more that real estate would capture a solid 10% of mixed asset portfolios. As noted, we’re still not there. Meanwhile, we’re told that tens of billions of dollars sit on the sidelines for investment in real estate from these very same institutional investors, but cap rates in the best markets have declined back down to extremely pricey 5-6% levels, and investors are having trouble putting out money—there’s not enough institutional grade product out there to satisfy even current demand.

Sure these pension funds can find plenty of properties in secondary and tertiary markets with anemic tenant demand and sluggish economic prospects, but they offer low returns with high risk. Are these the types of properties that will be vacuumed up by institutions as they increase their portfolios and boost allocations to 20%, while trying to satisfy growing retiree liabilities? Or will every municipal parking lot and toll road in the U.S. be turned over to private concessions in the next decade? Even in countries like the UK and Canada, which embrace public private infrastructure partnerships, the number of investments has been relatively limited.

All the user trends also suggest that tenants will want less space per capita not more in the decade ahead. It’s not like development will ramp up to provide lots of investment opportunities for institutions.

Or will stocks and bonds devalue to the point that real estate increases in value as part of total portfolios so the 20% threshold is met in a discomfiting denominator effect? Now I don’t feel good about the stock market right now, but if the other asset classes tank in value, real estate values will not be immune from the consequences.

And then will it matter much anyway? Pension plans will be in eclipse—their share of the investment pie will be shrinking anyway. Will 20% of a relatively much smaller piece of action be particularly meaningful?

Thank you, Scott Walker.